TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract. The TED spread is calculated as the difference between the three-month T-bill interest rate and three-month London Interbank Offered Rate (LIBOR).
If you want to know about the financial meltdown that quickly occurred...beginning in September...you'll want to know about the TED spread.
When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans is increasing. A rising TED spread often presages a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn.
On September 17, 2008, an all time record was set as the TED spread exceeded 300 bps. On October 10, the TED spread reached another new high of 465 basis points.
Why was this happening? Recall that the US government had to step in to help troubled Fannie Mae & Freddie Mac. Then Lehman Brothers was forced into bankruptcy. And insurance giant, AIG, had to be propped up by the federal government. These were matters of historic proportion that occurred together within 1 1/2 weeks.
This instilled fear among major lenders...and subsequently rattled the US consumer, causing them to rein in spending. This pushed the US into a recession.
Before September, the only part of the economy experiencing negative growth was the housing industry. Now with this liquidity crisis, the problem became widespread.
In technical terms, we witnessed a slowdown in the velocity of money. When that happened, the Fed was compelled to pump in an enormous amount of money into the US economy to offset this slowdown in spending.
This has helped greatly in the short run...and within a couple of years, the Fed will need to take action to avert a significant inflationary problem. But right now that's a problem they are willing to accept to avert another depression.
In the 1930s, the government made the opposite move. A move which made the liquidity problem much, much worse...and pushed the US into a depression.
It was this rapid jump in the TED spread that alarmed Fed Chairman Ben Bernanke. He realized he didn't have all the necessary tools to help the economy--so he contacted Treasury Secretary Hank Paulson.
Together they worked on this issue, along with help from incoming Treasury Secretary Tim Geithner. This was the genesis for the $700 Troubled Asset Relief Program (TARP) that was debated in Congress, and ultimately signed into law by President Bush in early October.
As you can see by the graph, TARP (and subsequent efforts by the Fed & Treasury) are working. While it definitely takes time to relieve a liquidity crisis, we are now seeing improvements in lending...and we are seeing some initial healing in the corporate bond markets.
The US economy has a long way to go. However, without the bold, new actions that were alertly taken this past fall, we would be in far worse shape as we enter the new year.
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